Influence of Monetary and Fiscal Policy on Aggregate Demand
ARSC 1432 Macroeconomics Co-Seminar
SPRING 2009
HOW MONETARY POLICY INFLUENCES AGGREGATE DEMAND
The downward slope of the aggregate demand curve:
(i)The Price Level and Consumption: The Wealth Effect
A decrease in the price level makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded
Remember: The nominal value of money is fixed, but is real value is not.
(ii)The Price Level and Investment: The Interest-Rate Effect
A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded.
(iii)The Price Level and Net Exports: The Exchange Rate Effect
When a fall in the U.S price level causes U.S. interest rates to fall, the real exchange depreciates, and this depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded.
For the U.S. economy, the most important reason for downward slope of the aggregate-demand curve is the interest-rate effect.
theory of liquidity preference.- Keyne’s theory that the interest rate adjusts to bring money supply and money demand into balance
Equilibrium in the Money Market
According to the theory of liquidity of preference, the interest adjusts to bring the quantity of money supplied and the quantity of money demanded into balance.
If the interest rate is above the equilibrium level, the quantity of money people want to hold is less that the quantity the Fed has created, and this surplus of money puts downward pressure on the interest rate.
Conversely, if the interest rate is below the equilibrium level, the quantity of money people want to hold is greater than the quantity the Fed has created, and this shortage of money puts upward pressure on the interest rate.
Thus, the forces of supply and demand in the market for money push the interest rate toward the equilibrium interest rate, at which people are content holding the quantity of money the Fed has created.
nterest rateMoney supply(Quantity Fixed by the Fed)
i1
i2
Money demand
M1 M2
The Money Market and the Slope of the Aggregate-Demand Curve
An increase in the price level form P1 to P2 shifts the money-demand curve to the right, as in panel (a). This increase in money demand causes the interest rate to rise from i1 to i2. Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded from Y1 to Y2. This negative relationship between the price level and quantity demanded is represented with a downward sloping aggregate-demand curve, as in panel (b)
(a) The Money Market (b) The Aggregate-Demand Curve
interest rate Money supplyPrice Level
(Quantity Fixed by the Fed)
i2
P2
i1
MD2 P2 P1
MD1 P1
AD
QUANTITY OF MONEY Y2 Y1 OUTPUT
A Monetary Injection
In panel (a), and increase in the money supply from MS1 to MS2 reduces the equilibrium interest rate from i1 to i2. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level from Y1 to Y2. Thus in panel (b), the aggregate-demand curve shifts to the right from AD1 to AD2
(a) The Money Market (b) The Aggregate-Demand Curve
interest rate MS1 MS2 Price Level
(Quantity Fixed by the Fed)
i1
P
i2
AD2
MD P
AD1
QUANTITY OF MONEY Y1 Y2 OUTPUT
When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right. Conversely, when the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the left.
multiplier effect.- the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.
marginal propensity to consume(MPC).- the fraction of extra income that a household consumes rather than saves.
For example, suppose that the marginal propensity to consume is ¾. This means that for every extra dollar that a household earns, the household spends $0.75(3/4 of the dollar) and saves $0.25.
The larger the MPC is, the greater is this induced effect on consumption, and the larger is the multiplier.
Multiplier = 1 / ( 1- MPC)
The multiplier tells us the demand for goods and services that each dollar of government purchases generates.
For example, if MPC is ¾, the multiplier is 1/(1-3/4), which is 4. In this case, the $20 billion of government spending generates $80 billion of demand for goods and services.
The Multiplier Effect
An increase in government purchases of $20 billion can shift the aggregate demand curve to the right by more than $20 billion. This multiplier effect arises because increases in aggregate income stimulate additional spending by consumers.
The Aggregate-Demand Curve
Price Level
$20 billion
AD3
AD2
AD1
OUTPUT
crowding out effect.- the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.
The Crowding-Out Effect
Panel (a) shows the money market. When the government increases its purchases of goods and services, the resulting increase in income raises the demand for money from MD1 to MD2, and this causes the equilibrium interest rate to rise from i1 to i2. Panel (b) shows the affect on aggregate demand. The initial impact of the increase in government purchases shifts the aggregate-demand curve from AD1 to AD2. Yet, because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the quantity of goods and services demanded, particularly for investment goods. This crowding out of investment partially offsets the impact of the fiscal expansion on aggregate demand. In the end, the aggregate-demand curve shifts only to AD3.
(a) The Money Market (b) The Shift Aggregate-Demand Curve
interest rate Money supplyPrice Level
(Quantity Fixed by the Fed)
i2
AD2
i1
MD2 P2 AD3
MD1 P1
AD1
QUANTITY OF MONEY OUTPUT
When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.
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